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Market-Based Cash Balance Plans
Minneapolis Pension CouncilDecember 19, 2013
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Outline
Brief cash balance overviewHistory of interest credit optionsIssues & answers
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Cash Balance Plan OverviewIt’s a DB plan that looks like a DC planBig DB deductions, DC-like simplicity
Cash Balance Plan ExampleDB/DC combo
Common for professional firmsEnables large deductible contributions for owners
Cash Balance Plan Example
Age2013Pay
CashBalance Credit
PS &3% Safe Harbor
401(k) & Catchup Total
Dr. F’stein 60 $255,000 $230,000 $33,500 $23,000 $286,500Igor 40 50,000 1,500 3,750 whatever 5,250+401kInga 30 30,000 900 2,250 whatever 3,150+401k
DB/DC combo: cash balance & profit sharingThis example is for a PBGC-covered plan, Frankenstein Mfg. Inc.Gateway here is 7½% DC; Igor & Inga get 3% cash balance creditsA PBGC-exempt professional firm may need to limit DC er contrs to 6%
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Cash Balance Buildup
Pay Credits + Interest Credits= Cash Balance!
Year Pay Credit
Interest Credit
(@ 10%)
Cash Balance
1 $100,000 $0 $100,000 2 100,000 10,000 210,0003 100,000 21,000 331,0004 100,000 33,100 464,1005 100,000 46,410 610,5106 100,000 61,051 771,5617 100,000 77,156 948,7178 100,000 94,872 1,143,5899 100,000 114,359 1,357,948
10 100,000 135,795 1,593,742
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History of Interest Credit Options
Notice 96-8 safe harborsPPA “statutory hybrid plan”: market rate of interestNotice 07-06: added 3rd funding segment rate10/19/2010 proposed regulations
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History of Interest Credit OptionsNotice 96-8: Bond indices w/ margins + 417(e) [30-Year T]
Standard Index Associated Margin
The discount rate on 3-month Treasury Bills 175 basis points
The discount rate on 6-month Treasury Bills or 12-month Treasury Bills
150 basis points
The yield on 1-year Treasury Constant Maturities 100 basis points
The yield on 2-year Treasury Constant Maturities or 3-year Treasury Constant Maturities
50 basis points
The yield on 5-year Treasury Constant Maturities or 7-year Treasury Constant Maturities
25 basis points
The yield on 10-year Treasury Constant Maturities or any longer period Treasury Constant Maturities
0 basis points
Annual rate of change of the Consumer Price Index 3 percentage points
Notice 07-06: long-term corporate bonds, PPA 3rd segment rate, 30-Year T, or rates in 96-8
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PPA – Statutory Hybrid Plan
Definition DB plan where portion of accumulated benefit is:
Current hypothetical account balance(cash balance plan); or
Accumulated percentage of final average pay (PEP plan)
What you get Whipsaw reliefAge-discrimination relief
What you give 100% vesting in 3 years (entire benefit)Interest Credit can’t exceed “market rate of return”
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History of Interest Credit Options2010 Proposed Regulations– Rate of return on plan assets, if prudently diversified 404(a)(1)(C)
– Rate of return on regulated investment company• Mutual funds (e.g., S&P 500 index)• Should not be more volatile than broad equity market
– Fixed 5.0% (with 411(d)(6) relief if switch from 3rd segment rate)
– “Greater of” rates [floors]• Max annual 4% floor if IC rate is fixed income safe harbor• Max cumulative 3% floor if equity-based IC rate
No final regulations yet
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History of Interest Credit OptionsInterest Credit Floor Example
Interest Credit = S&P 500 (actual from 2007 – Oct 2010)Principal Credit = $10,000 per year
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Interest Credit ExamplePreservation of Capital Example
Interest Credit = S&P 500 (actual from 2007 – Oct 2010)Principal Credit = $10,000 per year
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Market-Based CB Plan Issues
1. Investment risk (assets < cash balance accts)2. §401(a)(4) nondiscrimination testing3. Top-25 HCE lump sum restrictions4. Overfunding (account > §415 max lump sum)5. §401(a)(26) 50-ee/40% “meaningful benefits”6. DB accrual rules7. Administration – lump sum & annuity payouts
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Market-Based CB Plan Issues
1. Investment risk (assets < cash balance accts)Issue Answer
“Preservation of Capital” rule:• Payout can’t be less than sum of
pay credits• i.e. cumulative return for each
participant can’t be less than 0%
Investment risk can be lower than a traditional cash balance plan.
Can manage risk, but not escape it.
Possibilities include:• Conservative investments• Cap interest credits to capture
investment gains for plan sponsor• Delay distribution
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Market-Based CB Plan Issues
2. §401(a)(4) nondiscrimination testingIssue Answer
Successful nondiscrimination test may depend on “turbo charging”• DC contributions projected @ 8½%• CB credits projected at lower rate• CB credit produces a lower testing
benefit than an equal DC contrib
Market-based plan may project at a higher rate• Less turbo-charging advantage
IRS position is that CB testing should be done at previous year’s crediting rate.
Can improve passing chances with:• Conservative investments• Capped interest credits
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Market-Based CB Plan Issues
3. Top-25 HCE lump sum restrictionsIssue Answer
Funding “whipsaw”• CB account projected at market rate• Discounted back at low IRS rates• Produces liabilities higher than total
cash balance accounts• If assets < 110% of liability, can’t
pay lump sums to top 25 HCE’s
Current actuarial practice is to project accounts at expected long-term return.
Can improve results with:• Conservative investments• Capped interest credits• Extra funding to reach 110%
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Market-Based CB Plan Issues
4. Overfunding (account > §415 max lump sum)Issue Answer
With strong investment returns, individual account balance can exceed §415 maximum lump sum• Money is trapped in the plan• Excess subsidizes other
participants’ benefits
Can make it up outside the plan, or reduce risk with:• Conservative investments• Capped interest credits• Lower pay credits to “leave room”• Delayed distribution until §415
dollar limit catches up
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Market-Based CB Plan Issues
5. §401(a)(26) 50-ee/40% “meaningful benefits”Issue Answer
Benefits must be “meaningful” to count participant as covered in plan
IRS position (de facto safe harbor) isa pay credit generating a ½%-of-pay benefit at normal retirement age• Projections after a bad investment
year produces low benefits• Might not be enough people at ½%
to meet the 50-ee / 40% test
Can reduce risk with:• Conservative investments• A floor (e.g. 0-3% cumulative) on
interest credits
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Market-Based CB Plan Issues
6. DB accrual rulesIssue Answer
Need to satisfy DB accrual rules• Designed to prevent
“backloading” of benefit accruals to get around a vesting schedule
• 3 alternative rules, most cash balplans rely on 133-1/3% rule
• No future benefit accrual can be > 133-1/3% of earlier accrual
• Projections at low return rates produce low early accruals
Can reduce risk with:• Reduced age or service grading of
cash balance credits• Conservative investments• A floor (e.g. 0-3% cumulative) on
interest credits
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Market-Based CB Plan Issues
7. Administration – lump sum & annuity payoutsIssue Answer
Pure market-based account balance is unknowable beyond today• Need to provide survivor annuity
options in addition to lump sum payout
• Participant needs 30 days for annuity election
Can make balance knowable by:• Crediting actual return through
termination with payout reasonably soon thereafter, or
• Making all payouts after year end
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Contact Information
Mark Schulte, FSA, EA, [email protected]
Jim van Iwaarden, FSA, EA, [email protected]
Van Iwaarden Associates840 Lumber Exchange10 South Fifth StreetMinneapolis, MN 55402www.vaniwaarden.com1.888.596.5960
